Mankiw Principles of Microeconomics (4th ed)

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IN THE NEWS

Children as Externalities

THIS TONGUE-IN-CHEEK EDITORIAL FROM

THE Economist, an international newsmagazine, calls attention to a common externality that is not fully appreciated.

M u m ’s t h e W o r d :

W h e n C h i l d r e n S h o u l d B e S c r e e n e d a n d N o t H e a r d

We live in increasingly intolerant times. Signs proliferate demanding no smoking, no spitting, no parking, even no walking.

. . . Posh clubs and restaurants have long had “no jeans” rules, but these days you can be too smart. Some London hostelries have “no suits” policies, for fear that boisterous city traders in suits might spoil the atmosphere. Environmentalists have long demanded all sorts of bans on cars. Mobile telephones are the latest target: some trains, airline lounges, restaurants, and even golf courses are being designated “no phone” areas.

If intolerance really has to be the spirit of this age, The Economist would like to suggest restrictions on another source of noise pollution: children. Lest you dismiss this as mere prejudice, we can even produce a good economic argument for it. Smoking, driving, and mobile phones all cause what economists call “negative externalities.” That is, the costs of these activities to other people tend to exceed the costs to the individuals

When a transaction between a buyer and seller directly affects a third party, the effect is called an externality. Negative externalities, such as pollution, cause the socially optimal quantity in a market to be less than the equilibrium quantity. Positive externalities, such as technology spillovers, cause the socially optimal quantity to be greater than the equilibrium quantity.

Those affected by externalities can sometimes solve the problem privately. For instance, when one business confers an externality on another business, the two businesses can internalize the externality by merging. Alternatively, the interested parties can solve the problem by negotiating a contract. According to the Coase theorem, if people can bargain without cost, then

they can always reach an agreement in which resources are allocated efficiently. In many cases, however, reaching a bargain among the many interested parties is difficult, so the Coase theorem does not apply.

When private parties cannot adequately deal with external effects, such as pollution, the government often steps in. Sometimes the government prevents socially inefficient activity by regulating behavior. Other times it internalizes an externality using Pigovian taxes. Another way to protect the environment is for the government to issue a limited number of pollution permits. The end result of this policy is largely the same as imposing Pigovian taxes on polluters.

1.Give an example of a negative externality and an example of a positive externality.

2.Use a supply-and-demand diagram to explain the effect of a negative externality in production.

3.In what way does the patent system help society solve an externality problem?

4.List some of the ways that the problems caused by externalities can be solved without government intervention.

5.Imagine that you are a nonsmoker sharing a room with a smoker. According to the Coase theorem, what determines whether your roommate smokes in the room? Is this outcome efficient? How do you and your roommate reach this solution?

6.What are Pigovian taxes? Why do economists prefer them over regulations as a way to protect the environment from pollution?

1.Do you agree with the following statements? Why or why not?

a.“The benefits of Pigovian taxes as a way to reduce pollution have to be weighed against the deadweight losses that these taxes cause.”

b.“A negative production externality calls for a Pigovian tax on producers, whereas a negative

consumption externality calls for a Pigovian tax on consumers.”

2.Consider the market for fire extinguishers.

a.Why might fire extinguishers exhibit positive externalities in consumption?

b.Draw a graph of the market for fire extinguishers, labeling the demand curve, the social-value

curve, the supply curve, and the social-cost curve.

c.Indicate the market equilibrium level of output and the efficient level of output. Give an intuitive explanation for why these quantities differ.

d.If the external benefit is $10 per extinguisher, describe a government policy that would result in the efficient outcome.

3.Contributions to charitable organizations are deductible under the federal income tax. In what way does this government policy encourage private solutions to externalities?

4.Ringo loves playing rock and roll music at high volume. Luciano loves opera and hates rock and roll. Unfortunately, they are next-door neighbors in an apartment building with paper-thin walls.

a.What is the externality here?

b.What command-and-control policy might the landlord impose? Could such a policy lead to an inefficient outcome?

c.Suppose the landlord lets the tenants do whatever they want. According to the Coase theorem, how might Ringo and Luciano reach an efficient outcome on their own? What might prevent them from reaching an efficient outcome?

5.It is rumored that the Swiss government subsidizes cattle farming, and that the subsidy is larger in areas with more tourist attractions. Can you think of a reason why this policy might be efficient?

6.Greater consumption of alcohol leads to more motor vehicle accidents and, thus, imposes costs on people who do not drink and drive.

a.Illustrate the market for alcohol, labeling the demand curve, the social-value curve, the supply curve, the social-cost curve, the market equilibrium level of output, and the efficient level of output.

b.On your graph, shade the area corresponding to the deadweight loss of the market equilibrium. (Hint: The deadweight loss occurs because some units of alcohol are consumed for which the social cost exceeds the social value.) Explain.

7.Many observers believe that the levels of pollution in our economy are too high.

a.If society wishes to reduce overall pollution by a certain amount, why is it efficient to have different amounts of reduction at different firms?

b.Command-and-control approaches often rely on uniform reductions among firms. Why are these

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approaches generally unable to target the firms that should undertake bigger reductions?

c.Economists argue that appropriate Pigovian taxes or tradable pollution rights will result in efficient pollution reduction. How do these approaches target the firms that should undertake bigger reductions?

8.The Pristine River has two polluting firms on its banks. Acme Industrial and Creative Chemicals each dump 100 tons of glop into the river each year. The cost of reducing glop emissions per ton equals $10 for Acme and $100 for Creative. The local government wants to reduce overall pollution from 200 tons to 50 tons.

a.If the government knew the cost of reduction for each firm, what reductions would it impose to reach its overall goal? What would be the cost to each firm and the total cost to the firms together?

b.In a more typical situation, the government would not know the cost of pollution reduction at each firm. If the government decided to reach its overall goal by imposing uniform reductions on the firms, calculate the reduction made by each firm, the cost to each firm, and the total cost to the firms together.

c.Compare the total cost of pollution reduction in parts (a) and (b). If the government does not know the cost of reduction for each firm, is there still some way for it to reduce pollution to 50 tons at the total cost you calculated in part (a)? Explain.

9.Figure 10-5 shows that for any given demand curve for the right to pollute, the government can achieve the same outcome either by setting a price with a Pigovian tax or by setting a quantity with pollution permits. Suppose there is a sharp improvement in the technology for controlling pollution.

a.Using graphs similar to those in Figure 10-5, illustrate the effect of this development on the demand for pollution rights.

b.What is the effect on the price and quantity of pollution under each regulatory system? Explain.

10.Suppose that the government decides to issue tradable permits for a certain form of pollution.

a.Does it matter for economic efficiency whether the government distributes or auctions the permits? Does it matter in any other ways?

b.If the government chooses to distribute the permits, does the allocation of permits among firms matter for efficiency? Does it matter in any other ways?

11.The primary cause of global warming is carbon dioxide, which enters the atmosphere in varying amounts from

different countries but is distributed equally around the globe within a year. In an article in The Boston Globe (July 3, 1990), Martin and Kathleen Feldstein argue that the correct approach to global warming is “not to ask individual countries to stabilize their emissions of carbon dioxide at current levels,” as some have suggested. Instead, they argue that “carbon dioxide emissions should be reduced in countries where the costs are least, and the countries that bear that burden should be compensated by the rest of the world.”

a.Why is international cooperation necessary to reach an efficient outcome?

b.Is it possible to devise a compensation scheme such that all countries would be better off than under a system of uniform emission reductions? Explain.

12.Some people object to market-based policies to reduce pollution, claiming that they place a dollar value on cleaning our air and water. Economists reply that society implicitly places a dollar value on environmental cleanup even under command-and-control policies. Discuss why this is true.

13.(This problem is challenging.) There are three industrial firms in Happy Valley.

The government wants to reduce pollution to 120 units, so it gives each firm 40 tradable pollution permits.

a.Who sells permits and how many do they sell? Who buys permits and how many do they buy? Briefly explain why the sellers and buyers are each willing to do so. What is the total cost of pollution reduction in this situation?

b.How much higher would the costs of pollution reduction be if the permits could not be traded?

11

P U B L I C G O O D S A N D

C O M M O N R E S O U R C E S

An old song lyric maintains that “the best things in life are free.” A moment’s thought reveals a long list of goods that the songwriter could have had in mind. Nature provides some of them, such as rivers, mountains, beaches, lakes, and oceans. The government provides others, such as playgrounds, parks, and parades. In each case, people do not pay a fee when they choose to enjoy the benefit of the good.

Free goods provide a special challenge for economic analysis. Most goods in our economy are allocated in markets, where buyers pay for what they receive and sellers are paid for what they provide. For these goods, prices are the signals that guide the decisions of buyers and sellers. When goods are available free of charge, however, the market forces that normally allocate resources in our economy are absent.

In this chapter we examine the problems that arise for goods without market prices. Our analysis will shed light on one of the Ten Principles of Economics

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IN THIS CHAPTER YOU WILL . . .

Learn the defining characteristics of public goods and common r esour ces

Examine why private markets fail to pr ovide public goods

Consider some of the impor tant public goods in our economy

See why the cost - benefit analysis of public goods is both necessar y and dif ficult

Examine why people tend to use common r esour ces too much

Consider some of the impor tant common r esour ces in our economy

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excludability

the property of a good whereby a person can be prevented from using it

rivalr y

the property of a good whereby one person’s use diminishes other people’s use

private goods

goods that are both excludable and rival

public goods

goods that are neither excludable nor rival

common r esources goods that are rival but not excludable

How well do markets work in providing the goods that people want? The answer to this question depends on the good being considered. As we discussed in Chapter 7, we can rely on the market to provide the efficient number of ice-cream cones: The price of ice-cream cones adjusts to balance supply and demand, and this equilibrium maximizes the sum of producer and consumer surplus. Yet, as we discussed in Chapter 10, we cannot rely on the market to prevent aluminum manufacturers from polluting the air we breathe: Buyers and sellers in a market typically do not take account of the external effects of their decisions. Thus, markets work well when the good is ice cream, but they work badly when the good is clean air.

In thinking about the various goods in the economy, it is useful to group them according to two characteristics:

Is the good excludable? Can people be prevented from using the good?

Is the good rival? Does one person’s use of the good diminish another person’s enjoyment of it?

Using these two characteristics, Figure 11-1 divides goods into four categories:

1.Private goods are both excludable and rival. Consider an ice-cream cone, for example. An ice-cream cone is excludable because it is possible to prevent someone from eating an ice-cream cone—you just don’t give it to him. An ice-cream cone is rival because if one person eats an ice-cream cone, another person cannot eat the same cone. Most goods in the economy are private goods like ice-cream cones. When we analyzed supply and demand in Chapters 4, 5, and 6 and the efficiency of markets in Chapters 7, 8, and 9, we implicitly assumed that goods were both excludable and rival.

2.Public goods are neither excludable nor rival. That is, people cannot be prevented from using a public good, and one person’s enjoyment of a public good does not reduce another person’s enjoyment of it. For example, national defense is a public good. Once the country is defended from foreign aggressors, it is impossible to prevent any single person from enjoying the benefit of this defense. Moreover, when one person enjoys the benefit of national defense, he does not reduce the benefit to anyone else.

3.Common resources are rival but not excludable. For example, fish in the ocean are a rival good: When one person catches fish, there are fewer fish for the next person to catch. Yet these fish are not an excludable good because it is difficult to charge fishermen for the fish that they catch.

4.When a good is excludable but not rival, it is an example of a natural monopoly. For instance, consider fire protection in a small town. It is easy to

Figur e 11-1

FOUR TYPES OF GOODS.

Goods can be grouped into four categories according to two questions: (1) Is the good excludable? That is, can people be prevented from using it? (2) Is the good rival? That is, does one person’s use of the good diminish other people’s use of it? This table gives examples of goods in each of the four categories.